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Interest rate hikes are working: Bullock

Reserve Bank of Australia governor Michele Bullock defended the central bank's use of monetary policy and hiking interest rates amid many challenges that looks to keep inflation at stubborn levels over the next two years.

Speaking at the ASIC Annual Forum in Melbourne this morning, Bullock hailed monetary policy as a necessary yet "blunt tool" that stings the cash flow of Australians but is doing its job of keeping inflation down.

"[Monetary] policy doesn't just operate through the cash flow channel because it works in other countries where they don't have a strong cash flow channel. And it works here as well. It works through what economists call "intertemporal substitution"," she said, meaning that as interest rates rise, Australians are incentivised to save rather than spend.

Bullock pointed to the supply shocks and demand factors that she must consider if and when interest rates must increase.

She put to bed the current perception that inflation is only being driven by the supply side - such as the prices of petrol and energy and rent.

"[There is] actually an underlying demand component to it. That's what the central banks are trying to get on top of. It's often said that if there's just supply shocks, central banks should just look through them; let them naturally decline and come out of the numbers," she said.

"And we are observing a lot of that. That's why headline inflation has come down quite quickly overseas and has also come down in Australia."

Given that Australia has not recorded any meaningful growth in productivity over several years, Bullock worries that this will contribute to rising costs.

"We know that unit labour costs as measured in the last few years, have been rising quite substantially - 6%-8% - depending on how you might measure it. That's not helpful for inflation," she said.

Raphael Arndt, the chief executive of the Future Fund, who also appeared at the forum, warned that even if inflation declines it can stay volatile.

"Inflation is coming down, as we've said, right around the world, and it's a bit more advanced in a sense, in the US and Europe... But we've got this backdrop now of a whole lot of inflationary headwinds," Arndt said.

One example he pointed to is the path to decarbonisation that's not only important to the environment but from many countries' national security standpoint.

"[They] don't want to be reliant on importing oil from the Middle East or other countries that requires a whole lot of capital, a whole lot of investment that by its nature is inflationary," he said.

Another geopolitical risk that could aggravate inflation is the upcoming US election.

"We're seeing more and more populist governments getting elected. The nature of these things is [that more populist governments tend to] direct capital, intervene in markets more, not always for the purest economics point of view," he said.

As a result, such actions reduce potential economic growth and tend to be inflationary.

"Everytime a business decides to make an investment, they need a bigger return on that investment. It's not that the services sector workers don't deserve pay rises, it's just that there's a consequence to that if there are losses in productivity gains," he said.

Read more: Michele BullockRBA